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A lot of analysis that gets written will refer to "technical factors"
driving valuations. What this is referring to are situations where
unique factors are impacting valuations. The classic business school
example that comes to mind is the unique case of "flower bonds." These
were special issues of low-coupon U.S. Treasuries that could be used to
pay Federal estate taxes at par value; as a result, they traded at
extremely low yields. The unique nature of the mortgage and MBS markets
means that there are a number of situations that affect market levels,
and understanding them can help lenders and secondary market managers do
a better job of managing and hedging their pipelines.

An MBS-specific example of technical factors is so-called "convexity" buying and selling.
This refers to the fact that large bond market rallies and selloffs
tend to be self-perpetuating; big market moves often push yields beyond
levels that can be explained by changing economic expectations. Readers
of the MBS Commentary channel will have encountered this phenomenon as
"snowball" selling or buying.

To understand this, we first need to review several market fundamentals. Remember that the MBS market is huge, second only in size to the Treasury market.
Roughly $5.5 trillion in MBS issued under the auspices of Fannie Mae,
Freddie Mac, and Ginnie Mae are outstanding. (The MBS market used to be
larger than the Treasury market, but a few years of trillion-dollar
deficits changed that dynamic.)

In addition, mortgages are prepayable at the option of the homeowners. Any investor or portfolio manager holding MBS or mortgage-related securities
has to make some judgment on how rapidly their holdings will prepay.
(That's why prepayment metrics are referred to as "speeds.") When
interest rates decline, investors will assume faster prepayment speeds
for their holdings, which means that their portfolios are effectively
getting "shorter" in both average life and price sensitivity to rate
moves, i.e., duration. If rates rise, the opposite happens; investors
assume slower prepayments, which in turn extend the average lives and
durations of their holdings.

This means that investors both large and small need
to adjust the duration profile of their portfolio when interest rates
change, especially if they are "index" investors that track the duration
of major market indices. Since rate declines (i.e., rising bond
prices) are associated with shortening durations, investors need to buy
assets in order to maintain their portfolio's duration, perpetuating the
rally. Alternatively, rising rates are associated with the selling of
duration (either MBS or any fixed-income asset with positive duration)
by investors, pushing bond prices still lower.

These activities tend to push market moves beyond
what would be associated with simple changes in expectations, and are
referred to as "convexity buying" or "convexity selling" because they
result from the negatively-convex nature of MBS. (I'll discuss
convexity in a future post.) Understanding this phenomenon can help
investors gauge the intensity and duration of market moves, and adjust
their responses accordingly. (Note that the fact that the Federal
Reserve holds over $1 trillion of agency MBS has dampened this response a
bit; the Fed is a "passive" investor and does not adjust its holdings
to changing rate levels.)

Next Time: Technical Factors Part 2: Dollar Rolls

About the Author

Bill Berliner is Executive Vice President of Manhattan Capital Markets, and runs its advisory business. He focuses on working with mortgage originators on issues related to pipeline hedging, asset valuation, and business management issues.
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